Chapter 8: Taxation of Individuals8-1
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CHAPTER 8
TAXATION OF INDIVIDUALS
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DISCUSSION QUESTIONS
1.What is the difference between a personal exemption and a dependency exemption? Are all taxpayers allowed a personal exemption?
Both types of exemptions are worth the same amount in terms of a deduction. Personal exemptions are allowed to the taxpayer(s) filing the return (this can never be greater than two), while dependency exemptions are allowed for those individuals who qualify as a taxpayer's dependent.
Not all taxpayers are entitled to a personal exemption. A taxpayer that is claimed as a dependent of another is not allowed a personal exemption deduction. The effect of this provision is to allow only 1 exemption deduction per individual. Note: If there is total tax compliance, then the total number of exemptions taken equals the total U.S. population. However, two factors, administrative convenience and tax evasion, prevent this from happening. For purposes of administrative convenience, the government does not require every taxpayer to file a return. Other taxpayers who are required to file a return choose not to file -- tax evasion.
2.What are the five tests that must met for an individual to be considereda dependent as a qualifying child? as a qualifying relative? Briefly explain each test.
The 5 qualifying child tests are:
1.Age Test. To meet the age test, the individual must be under the age of 19 at the end of the year, a full-time student under the age of 24 at the end of the year, or be permanently and totally disabled.
2.Non-Support Test. To meet the support test, the individual being claimed as a dependent must not have provided more than one-half of their support.
3.Relationship Test. Under the relationship test an individual must be the taxpayer’s son, daughter, stepson, stepdaughter, eligible foster child or decedent of such a child, or the taxpayer’s brother, sister, stepbrother, stepsister or any descendant of any such relative.
4.Principal Residence Test. To meet the principal residence test, the individual must live with the taxpayer for more than one-half of the year. Temporary absences due to illness, vacation, education, military service or other special circumstances are not considered as time living away from the principal residence.
5.Citizenship or Residency Test. Under the citizenship or residency test, the child must be a citizen or resident of the United States, or a resident of the United States, Canada or Mexico.
The 5 qualifying relative tests are:
1.Gross Income Test - the gross income of a dependent cannot exceed the amount of the exemption deduction.
2.Support Test - the taxpayer seeking the exemption must pay more than 1/2 of the amount spent on the dependents support. Only amounts spent on support are considered in this test, not the amounts the dependent may have earned but did not spend on support.
3.Relationship or Member of Household Test - the dependent must be either a relative or a member of the taxpayer's household for the entire year. A relative is defined as lineal descendants (ancestor, daughter) and blood relatives (aunt, nephew).
4.Citizen or Residency Test - a dependent must be either a U.S. citizen or a resident of the U.S., Canada, or Mexico for at least part of the year.
5.Joint Return Test - a dependent cannot file a joint return, unless the only purpose for filing the return is to obtain a refund of taxes paid-in. That is, they are not required to file under the filing requirements.
3.Which parent is entitled to claim the dependency exemption for a child when the parents are divorced? Can the other parent ever claim the dependency exemption?
The custodial parent is entitled to the deduction, regardless of the level of support the non-custodial parent may provide. There are 2 possible ways that the non-custodial parent can claim the exemption deduction. First, the divorce decree may specify that the non-custodial parent is entitled to the dependency exemption(s). Second, the custodial parent can give the deduction to the non-custodial parent by written agreement. The agreement must be attached to the non-custodial parent's tax return.
5.Why is a taxpayer's filing status important?
Filing status is important because it determines which tax rate schedule the taxpayer must use to calculate the tax, the amount of the standard deduction, and the income level at which the phase-out of the exemption deduction begins.
6.What is a surviving spouse? Explain the tax benefit available to a surviving spouse.
A surviving spouse is a single taxpayer whose spouse died within the last two years and who has a dependent child living in the home.
The tax benefit is that a surviving spouse files using the same tax benefits as a married couple filing jointly receives for two years following the year of death. In the year of the spouse’s death, a joint return is filed. This provides a surviving spouse with a larger standard deduction and lower average tax rates than the individual would have received under the head of household filing status.
7.Under what circumstances can a married person file as a head-of-household?
The tax law allows an abandoned spouse to file as a head of household. To qualify, the taxpayer must be married at the end of the year, have a dependent child living in the home for more than 1/2 the year, and the taxpayer's spouse has not lived in the home during the last 6 months of the year.
PROBLEMS
30.Determine whether each of the following individuals can be claimed as a dependent in the current year. Assume that any tests not mentioned have been satisfied.
a.Nico is 20 and a full-time college student who receives a scholarship for $11,000. Tuition, books, and fees total $15,000. His father gives him an additional $6,000 to pay for room and board and other living expenses.
Nico meets all the tests as a qualifying child. Even though he used the scholarship for his support, scholarships are not considered support. Therefore, the non-support test is met and Nico is a dependent.
b.Lawrence pays $7,800 of his mother's living expenses. His mother receives $3,500 in Social Security benefits and $4,100 from a qualified employer retirement program, all of which is spent on her support.
Lawrence's mother fails the gross income test. Her gross income for tax purposes is $4,100 (pension), which is greater than the $3,400 exemption amount. The Social Security benefits are not included in gross income because her AGI is less than $25,000.
c.Megan's father has no sources of income. During the year, Megan pays all of her father's support. He is a citizen and resident of Australia.
Megan's father is not a dependent. The citizen or residency requirement is met if the dependent is a citizen or resident of the United States, Canada, or Mexico for any part of the tax year. Therefore, Megan’s father does not meet the residency requirement.
d.Tawana and Ralph are married and full-time college students. They are both 22 years old. Tawana works as a model and earns $4,300 and Ralph earns $2,100 during the year. Tawana and Ralph are not required to file a joint return and do so only to receive a refund of the taxes withheld on their respective incomes. Tawana's parents give them an additional $8,000 to help them through college.
Because Tawana and Ralph are not required to file a joint return, Tawana can be claimed as dependent by her parents under the qualifying child rules. Ralph can also be claimed as a dependent under the qualifying relative rules since his gross income is less than $3,400. If his gross income exceeded $3,400, he would not have met the gross income test.
33.Determine the 2007 filing status in each of the following situations:
a.Michaela and Harrison decide to separate on October 12, 2007. Before filing their 2007 tax return on February 18, 2008, Michaela files for and is granted a formal separation agreement.
Marital status is determined on the last day of the tax year. Because Michaela and Harrison are not legally separated on December 31, they are considered to be married for 2007. If they cannot agree to file a joint return, each must file a return as married filing separately.
b.Simon is single and owns a condominium in Florida. His father lives in the condominium, and Simon receives $1,000 per year from his father as rent. The total expenses of maintaining the condominium are $15,000. His father receives a pension of $25,000 and Social Security benefits of $8,000.
Simon is single. To obtain head of household status for support of his father, he must qualify as Simon’s dependent. He cannot be treated as a qualifying relative because his gross income ($25,000) exceeds the $3,400 personal exemption amount, so he fails the gross income test.
c.Nick is 32 years old and lives with his mother. He earns $36,000 a year and pays $4,000 a year toward the cost of maintaining the household. His mother, who is single, earns $60,000 and pays $8,000 toward the cost of maintaining the household.
Nick’s mother must file as single because Nick cannot be claimed as a dependent under either the qualifying child or qualifying relative tests.
d.Jamal’s wife died in 2005. He maintains a household for his twin daughters who are seniors in high school.
Jamal may file as a surviving spouse (i.e., at joint return rates, deductions, etc.) because he has two dependent children who still live in his home. This filing status is only allowed for 2006 and 2007. Instructor’s Note: To be a surviving spouse for 2006 and 2007, at least one of his daughters must still live with him and is a qualifying child or qualifying relative. Beginning in 2008, Jamal’s filing status will be head of household.
e.Kathy and Sven are married with two children, ages 14 and 12. In June, Kathy leaves Sven and their children. Sven has not heard from Kathy, but a former coworker of Kathy’s tells Sven that Kathy wanted to move to Ireland.
Assuming that Sven provides more than half of the cost of maintaining the home, he can file as a head of household under the abandoned spouse rule. NOTE: If Kathy had left the home after June 30, the last half of the year requirement would not be met and Sven would have to file as married filing separately. He most likely could not file a joint tax return as both taxpayers must sign the return.
34.Determine the maximum deduction from AGI in 2007 for each of the following taxpayers:
a.Pedro is single and maintains a household for his father. His father is not a dependent of Pedro’s. Pedro’s itemized deductions are $6,400.
He will use his itemized deductions of $6,400 because it exceeds the standard deduction of $5,350 for a single taxpayer.
b.Jie and Ling are married. Jie is 66 years old, and Ling is 62. They have itemized deductions of $11,900.
They will use their itemized deductions of $11,900 because it exceeds their standard deduction of $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for Jie being over age 65).
c.Myron and Samantha are married, and both are 38 years of age. Samantha is legally blind. They have itemized deductions of $10,500.
Their standard deduction is $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for blindness). They will deduct the standard deduction because it is greater than their itemized deductions of $10,500.
d.Joelynn is divorced and maintains a home for her 21-year-old son, who is a part-time student at the local university. He pays less than one-half of his support and his earned income for the year is $3,000. Her itemized deductions are $7,200.
She will use the standard deduction for head of household of $7,850 because it exceeds her itemized deductions of $7,200. Joelynn qualifies as head of household because her son’sgross income is less than $3,400 (the personal exemption amount). Therefore, Joelynn would meet all the tests for her son to be considered a qualifying relative.
e.Frank is 66 years of age. During the year, his wife dies. His itemized deductions are $10,400.
For 2006, Frank is considered married. His standard deduction is $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for being over age 65). He will deduct the standard deduction because it is greater than his itemized deductions of $10,400.
f.Assume the same facts as in part e, except that Frank’s wife dies in 2006.
For 2007, Frank is considered single (he doesn’t qualify for surviving spouse because he has no dependent children living in the home). His standard deduction is $6,650 ($5,350 regular standard deduction + $1,300 additional deduction for being over age 65). He will deduct his itemized deductions of $10,400 because it is greater than his standard deduction. Note: Frank does not receive any benefit (i.e., an increase in his itemized deductions) for being over 65. Being over 65 can only increase his standard deduction.
36.Hongtao is single and has a gross income of $89,000. His allowable deductions for adjusted gross income are $4,200 and his itemized deductions are $12,300.
a.What is Hongtao’s taxable income and tax liability for 2007?
Hongtao’s taxable income is $69,100:
Gross income$ 89,000
Deductions for AGI (4,200)
Adjusted gross income$ 84,800
Deductions from AGI
The greater of:
Standard deduction$ 5,350
or
Itemized deductions$12,300 (12,300)
Personal exemption (3,400)
Taxable income$ 69,100
Hongtao’s tax is $13,699. From the 2007 tax rate schedule, the tax on $69,100 is:
$4,386.25 + [25% x ($69,100 - $31,850)] = $13,699
b.If Hongtao has $13,900 withheld from his salary during 2007, is he entitled to a refund or does he owe additional taxes?
Hongtao has a refund of $201 ($13,699 - $13,900).
c.Assume the same facts as in parts a and b, except that Hongtao is married. His wife’s salary is $30,000, and she has $3,200 withheld from her paycheck. What is their taxable income and tax liability for 2007? Are they entitled to a refund, or do they owe additional taxes?
Their joint taxable income is $95,700:
Gross income ($89,000 + $30,000)$ 119,000
Deductions for AGI (4,200)
Adjusted gross income$ 114,800
Deductions from AGI
The greater of:
Standard deduction$10,700
or
Itemized deductions$12,300 (12,300)
Personal exemption (2 x $3,400) (6,800)
Taxable income$ 95,700
Their tax liability is $16,773. From the 2007 tax rate schedule, the tax on $95,700 is:
$8,772.50 + [25% x ($95,700 - $63,700)] = $16,773
They will receive a refund of $327 [$16,773 - ($13,900 + $3,200)].
37.Arthur and Cora are married and have 2 dependent children. For 2007, they have a gross income of $88,000. Their allowable deductions for adjusted gross income total $4,000, and they have total allowable itemized deductions of $14,250.
a.What is Arthur and Cora's 2007 taxable income?
Arthur and Cora have a taxable income of $56,150:
Gross income$ 88,000
Deductions for AGI (4,000)
Adjusted gross income$ 84,000
Deductions from AGI:
The greater of:
Itemized deductions$ 14,250
or
Standard deduction$ 10,700 (14,250)
Personal and dependency exemptions (4 x $3,400) (13,600)
Taxable income$ 56,150
b.What is Arthur and Cora's 2007 income tax?
The tax on a married couple filing jointly in 2007 is $7,640. Their net tax liability after the child tax credit is $5,728.
$1,565.00 + [15% x ($56,150 - $15,650)]=$ 7,640
Less: Child tax credit (2 x $1,000) (2,000)
Net tax liability$ 5,640
c.If Arthur has $2,900 and Cora has $3,000 withheld from their paychecks during 2007, are they entitled to a refund, or do they owe additional taxes?
They are entitled to a refund of $260 [$5,640 - ($2,900 + $3,000)].
38.Rebecca and Irving incur the following medical expenses during the current year:
Medical insurance premiums$4,100
Hospital 950
Doctors 1,225
Dentist 575
Veterinarian 170
Chiropractor 220
Cosmetic surgery 1,450
Over-the-counter drugs 165
Prescription drugs 195
Crutches 105
They receive $4,000 in reimbursements from their insurance company of which $300 is for the cosmetic surgery. What is their medical expense deduction if
a.Their adjusted gross income is $44,000?
Rebecca and Irving’s allowable medical costs before reimbursement are $7,370. The cosmetic surgery, veterinarian fees, and the over-the-counter drugs are not allowable medical expenses. Their unreimbursed medical costs are $3,670 [$7,370 - $3,700 ($4,000 - $300)]. The $4,000 reimbursement is reduced by the $300 reimbursement for the cosmetic surgery. The $3,670 of medical expenses is subject to the 7 1/2% AGI limitation.
Their allowable deduction is $370:
Medical insurance premiums$ 4,100
Hospital 950
Doctors 1,225
Dentist 575
Chiropractor 220
Prescription drugs 195
Crutches 105
Total Allowable medical expenses$ 7,370
Less: Insurance reimbursements (3,700)
Unreimbursed medical expenses$ 3,670
Less: AGI limitation ($44,000 x 7.5%) (3,300)
Medical expense deduction$ 370
b.Their adjusted gross income is $61,000?
No deduction is allowed. The AGI limit is $4,575 ($61,000 x 7.5%), which is greater than their $3,670 of unreimbursed costs.
40.Paula lives in Kansas which imposes a state income tax. During 2006, she pays the following taxes:
Federal tax withheld5,125
State income tax withheld1,900
State sales tax – actual receipts 370
Real estate tax1,740
Property tax on car (ad valoreum) 215
Social Security tax4,324
Gasoline taxes 124
Excise taxes 112
a.If Paula’s adjusted gross income is $35,000 what is her allowable deduction for taxes?
Paula is allowed an itemized deduction, the real estatetax and the property taxes she paid on the car during the year. In addition, she can elect to deduct the greater of the amount she paid in state income taxes or the amount of her sales tax deduction. In determining the amount of her sales tax deduction, Paula deducts the greater of the actual amount paid in sales tax or the IRS table amount. She can also add to the table amount any taxes she paid to acquire motor vehicles, boats, and other items specified by theIRS.
Because the table amount of $530 is greater than the actual amount of $370, her sales tax deduction is $530. Since the amount Paula paid in state income taxes ($1,900) is greater than her sales tax deduction, Paula would deduct her state income taxes. The Social Security, gasoline and excise taxes are not allowable taxes. The federal income tax withheld is not a deductible tax but is a prepayment of Paula's federal tax liability. Paula’s deduction for taxes is $3,855:
State income tax withheld$1,900
Real estate tax 1,740
Property tax on car (ad valorem) 215
Total tax deduction$3,855
b.Assume the same facts as in part a, except that Paula pays $1,600 in sales tax on a motor vehicle she purchased during the year. What is Paula’s allowable deduction for taxes?